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It should have been a day of celebration as the Euro welcomed Croatia as the 20th country.
But while finance ministers were endorsing the newest member of their club, the single currency slid toward an unwelcome milestone: parity with the US dollar.
Analysts are now wondering how far the euro could fall, amid fears that the currency’s rapid depreciation this year could exacerbate the cost of living of misery for hundreds of millions of Europeans.
Ultimately, as rising energy costs and inflation put pressure on living standards, there may be a political price to pay.
“The drop in the euro has more room to run,” the chief economist at the Institute of International Finance, Robin Brooks, tweeted on Sunday. “We are only at the beginning.”
On Tuesday, the euro briefly hit parity against the US dollar for the first time in 20 years. The last time the euro was worth less than the dollar was in 2002, when euro money was in its infancy and was only shared by 12 member states.
The single currency has lost more than 10 percent of its value against the dollar since the beginning of the year. It was a fast slide, driven in part by the deteriorating growth outlook in the eurozone thanks to Russia’s invasion of Ukraine, and increased demand for the dollar as a safe-currency.
As always, not everyone will see it as bad news. There are advantages to a declining currency, which is that exports become cheaper and more attractive. But European Commissioner for Economics Paolo Gentiloni warned that it would be “a mistake” to see the euro fall on these terms.
“Of course it encourages export capacity, but we also have to look at the negative side of this currency,” he said at a press conference on Monday.
A weaker euro makes imports more expensive – adding to inflation pressures.
One policymaker who has warned of this danger is François Villeroy de Gallo, a member of the European Central Bank’s Governing Council. He warned earlier this year that the central bank would “carefully monitor developments in the effective exchange rate, as an important driver of imported inflation.”
“A very weak euro goes against our goal of price stability,” he added.
A paper from the European Central Bank published in 2020 cited models estimating that a 1 per cent depreciation of the euro against a basket of currencies could add up to 0.11 percentage points to inflation within a year — and 0.25 percentage points over three years.
No bottom yet?
Analysts are warning that the euro may not have bottomed out given the continuing risks that a Russian gas cut could push the region into a deep recession.
Some suggested that 1 euro drop to 90 US cents in the dreary event but not impossible for Russia Does not restart Nord Stream 1 gas pipeline.
This scenario, in turn, could significantly constrain the ECB’s ability to raise interest rates, which it has not yet done. It is expected to raise benchmark interest rates by 25 basis points on July 21, when it holds its next policy meeting, and may announce a larger increase in September.
By contrast, the US Federal Reserve went ahead, aggressively forcing the dollar to raise interest rates.
“The Fed continues to be seen as having more room to raise interest rates in the future, also on the back of a strong US jobs report for June,” Roberto Mialic, foreign exchange analyst at UniCredit, explained in a research note. On the other hand, other central banks, such as the European Central Bank and [Bank of England]They may have to become more prudent, given the direct exposure of their economies to the gas and energy crisis.”
Meanwhile, the dollar is benefiting from safe haven flows, as investors flock to US government bonds as a hedge against economic and political uncertainty.
If the euro continues to decline, “no doubt [the ECB] Chris Turner, an economist at ING, said the move would be very worrying – especially if it developed into a “eurozone sell-off” mentality. However, in the face of a looming recession risk – and the euro is a procyclical – the ECB’s hands may be constrained in its ability to threaten more aggressive rate hikes in defense of the euro.
The concern over the euro came on the day EU finance ministers gave final approval for Croatia’s membership in the eurozone, enabling it to adopt the single currency from January 2023.
“The fact that Croatia will become the 20th member of the European Monetary Union area is also a clear indication that European integration continues despite all the challenges we face,” said Zdravko Maric, outgoing Croatian Finance Minister.
Tuesday’s formal procedures complement the years-long accession procedure, which requires countries to comply with a number of criteria such as price, exchange rate and interest rate stability, as well as budget discipline and a moratorium on monetary financing.
Croatia will also have a seat at the table of the European Central Bank’s Board of Governors – as an observer from September, and as a full member in January.
While welcoming Croatia into the group, European Central Bank President Christine Lagarde said membership requires adherence and respect for the rules, adding: “It’s a wonderful club to be a member of.”
Tim Ross contributed reporting.
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